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Corporate Finance : Dollar Bounces Back As Fed Hits Pause Button

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The dollar rose to a two-month high against the euro last month after the Federal Reserve signaled a pause in its easing cycle, and European economic data came in weaker than expected. While the greenback is unlikely to continue to rally in the face of a still-hawkish European Central Bank (ECB), the dollar could be entering a period of relative stability, analysts say.

A slew of poor economic indicators from the eurozone, including a surprising decline in retail sales in March, released in early May, supported the belief that Europe won’t escape the economic difficulties being felt in the United States, says Mark Frey, head trader at Custom House, a global payments company and foreign exchange dealer based in Victoria, British Columbia, Canada.

Industrial orders in Germany also declined in March, and the French trade deficit widened. Meanwhile, it was the smaller members of the EU that bore the brunt of the declines in retail sales, with Slovenia, Portugal and Luxembourg sustaining the biggest drops in spending, according to Frey. “This is one trend that we see as a potential problem for the EU, as the economic goals and prospects of the French and Germans clash with the smaller nations that aren’t experiencing the same inflationary pressures,” he says.

ECB president Jean-Claude Trichet has failed to dampen his hawkish stance despite softening eurozone growth and inflation data, says Michael Woolfolk, senior currency strategist at The Bank of New York Mellon. The ECB kept its benchmark interest rate unchanged at 4% at its May meeting, and in the accompanying press briefing Trichet said the euro area’s economic fundamentals were sound.

“We are currently experiencing a protracted period of high inflation rates,” Trichet said. “It’s imperative that they don’t become entrenched in long-term expectations.” What’s more, he said that the word “vigilance” had not disappeared from his vocabulary and that he would use it when the time was right. “We have to remain very cautious and prudent,” he said. He went on to say that inflation was volatile and had been very high for many months.

The conclusion to be drawn is that the ECB is prepared to raise interest rates if second-round effects from elevated energy and food prices begin to emerge, Woolfolk says. “Trichet threw a bucket of cold water on the dollar’s rally by erasing any hopes for a rate cut later this year and giving players every reason to believe the next move may be higher,” he says.

CURRENCY FORECASTS

The Bank of England left its key interest rate unchanged at 5% in May, as expected, opting not to make back-to-back monthly cuts to help stimulate economic growth as inflation remained high. “The bank is widely expected to stick to its pattern of cutting rates in alternating months, thus reducing rates in June to 4.75%,” says Ashraf Laidi, chief foreign exchange strategist at CMC Markets US, based in New York. “We continue to expect [UK rates to decline to] 4% by year-end,” he says. The pound is expected to maintain its predominantly weak tone against the other major currencies, he predicts.

Meanwhile, the dollar got a boost from comments by Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, who warned that inflation could become embedded in the US economy. If inflation remained high, it may force a significant rate hike, according to Hoenig, a veteran Fed official who is not currently a voting member of the Federal Open Market Committee.

Hoenig’s remarks reinforced the view that there is little scope or appetite for additional rate cuts, says Marc Chandler, global head of currency strategy at Brown Brothers Harriman, based in New York, adding that “more pieces of the more-positive dollar puzzle are falling into place.” The relaxation of Fannie Mae’s lending limits and reports that the Fed is seeking Congressional approval to pay interest on reserves held by commercial banks point to the use of non-interest-rate mechanisms aimed at preventing a more serious downturn in the economy, according to Chandler.

“We do believe that the ECB will ultimately have to cut rates to counter slower-than-expected growth,” Chandler says. “Our view of a dollar recovery was partly based on US developments, like the economic downturn being short and shallow, and also was based on developments [in economies] abroad deteriorating more than was generally appreciated,” he says.

David Gilmore, partner and economist at Foreign Exchange Analytics, based in Essex, Connecticut, says the US administration’s view of the dollar changed ahead of the April meeting of the Group of 7 finance ministers of the major industrialized nations. The US Treasury and the White House felt that the weak dollar was doing all it could to help growth by making exports more competitive, but that continued weakness in the greenback risked worsening inflation, particularly in light of the connection between the dollar and the price of oil and other commodities, Gilmore says.

It is a safe bet that the US administration does not want to see a sharply higher dollar and that what it is seeking is stability, according to Gilmore. The April G-7 communiqué expressed concern about sharp fluctuations in major currencies.

“The ECB is still Zeus atop Mount Olympus, the great protector of price stability, punishing those demanding a growth-oriented monetary policy,” Gilmore says. “It is ironic that the US has embraced the notion, after several years of urging, to put an end to the dollar’s decline, and yet the ECB is a no-show when it comes to introducing downside risks for interest rates in the eurozone,” he says.

Analysts at London-based Barclays Capital say they expect the euro to bounce back from its recent decline against the dollar. The strength in oil prices and the weakness of the dollar have created a vicious circle that remains in place, they say. The dollar’s recent appreciation has sparked the notion that the euro’s seven-year bull run was coming to an end, says David Woo, head of global foreign exchange strategy at Barclays Capital. “In our view, as long as America’s real interest rates remain low and China’s demand for commodities stays strong, the scope for further dollar rallies is likely to be limited,” he says.